What you need to know about the death of IRA recharacterizations.
By Christine Benz | 02-08-18 | 05:00 AM | Email Article

As members of Congress debated changes to the tax code in late 2017, several substantive retirement-related ideas were on the table, including a proposal to cap pretax contributions to workplace retirement plans, effectively steering more and more savers to the Roth option. 

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

When the laws were finalized, however, those more controversial provisions went by the wayside, and very little about the retirement-planning landscape actually changed. There's a notable exception, however: The new tax laws put an end to what's called an IRA recharacterization, a strategy that enables retirement savers to reverse an IRA conversion--switching a traditional IRA back to a Roth or vice versa.

The IRA recharacterization offered a valuable escape hatch to IRA converters: If a conversion turned out to be too costly from a tax standpoint or otherwise ill-advised, the IRA could be returned to its initial state.  

With recharacterizations of IRA accounts converted this year or after now off the table, here's what you need to know.

Q: What's an IRA recharacterization, anyway?

A: The starting point for understanding IRA recharacterizations is understanding IRA conversions. With the typical IRA conversion, an investor converts some or all of her traditional IRA assets to Roth. By undertaking such a conversion, the investor must pay taxes on any dollars in the IRA that hadn't yet been taxed--deductible contributions and investment appreciation. For many IRA holders, ordinary income tax is due on the whole account value at the time of conversion, because none of that money has ever been taxed. In exchange, the investor who converts traditional IRA assets to Roth can take tax-free withdrawals from the account in retirement, provided he or she is older than 59 1/2 and has met the five-year holding requirement. Moreover, Roth IRAs, in contrast with traditional, do not carry required minimum distributions, making Roths attractive for investors who would like their accounts to continue to enjoy tax-free growth throughout their retirement years.

But what if the conversion turned out to be ill-advised? A recharacterization effectively reverses the conversion. For example, let's say an investor converted her traditional IRA to a Roth shortly before the market dropped precipitously. With a recharacterization, she could put the money back into a traditional IRA, along with any gains or losses since the conversion, sidestepping the taxes she would have owed on the conversion when her balance was higher. She could then revisit the conversion at a later date, ideally when her balance was lower and the taxes due on the conversion would be lower, too. Recharacterizations can also come in handy if the taxes due upon conversion were higher than expected, or if the investor doesn't have the cash on hand to pay conversion-related taxes. (Taking additional money out of the IRA to cover the conversion-related taxes is a bad idea, as it will trigger additional taxes, as well as a penalty for people who aren't yet 59 1/2.)   

Q: What's changing? 

A: The new tax laws state that any conversions undertaken in 2018 or thereafter cannot be recharacterized. That means that would-be IRA converters will need to stick with their conversions--and pay any taxes due upon them as well--from here on out. Do-overs are over for new conversions.

Q: I converted some traditional IRA assets to Roth in 2017. Does this mean I can't recharacterize them?

A: No. The new tax laws pertain to conversions undertaken in 2018 and beyond, but IRAs that were converted in 2017 are still eligible for recharacterization. Just be sure to mind the deadline. As noted in an IRA FAQs on the IRS website, conversions completed in 2017 are eligible for recharacterization until Oct. 15, 2018.

Q: What happens if I contribute to the wrong IRA type and need to change it? Does that count as a recharacterization?

A: No. As Baird director of advanced planning notes in this video, investors who inadvertently contribute to the wrong type of IRA--whether Roth or traditional--can still recharacterize back to the other contribution type. For example, let's say an investor makes a Roth IRA contribution but later discovers that his income was above the limits for a direct Roth IRA contribution. In that case, he could recharacterize the IRA to a traditional IRA.

Q: Now that this escape hatch has closed, what should I bear in mind if I'm contemplating a conversion?

A: Because there are no more conversion do-overs, it's crucial to think through the tax and other ramifications of the conversion before undertaking it. Check with a tax advisor to make sure that the long-term benefits of the conversion outweigh any taxes you'll owe on the conversion. Partial conversions--which enable you you convert just enough of a traditional IRA balance to avoid pushing yourself into a higher tax bracket--are arguably more advisable than ever. If you do a partial conversion that turns out to be a mistake, at least it won't be a catastrophic mistake. 

Q: Is the backdoor Roth IRA affected by the new rules on recharacterizations? You have to do a conversion to get in through the back door.

A: To some extent, yes. With a backdoor Roth IRA, an investor who earns too much to make a direct Roth IRA contribution can make an indirect contribution using a two-step process. He or she first makes a traditional IRA contribution (no income limits apply for traditional IRA contributions that aren't deducted on a tax return), then shortly thereafter converts the traditional IRA assets to a Roth IRA. The new ban on recharacterizations has significance for backdoor Roth IRA investors because the conversion piece of the process cannot be undone, even if it turns out to be regrettable. One common instance of a regrettable conversion would be if the investor owns other traditional IRA assets--apart from the assets he or has just converted. In that case, the taxes due on the converted amount would be based on the ratio of never-been-taxed assets and already-been-taxed assets across all of the investor's IRAs. This article takes a closer look at this potential pitfall of the backdoor Roth IRA maneuver.

Q: Are 401(k)s affected? I have some traditional 401(k) assets that I'd like to convert to Roth eventually.

A: Not really. If your 401(k) plan offers what's called an "in-plan conversion" option, which enables investors to convert their traditional 401(k) assets to Roth 401(k) assets, the recharacterization change doesn't affect you: Recharacterization of assets converted in plan was not allowed before and it's not allowed now. However, if your plan is to roll your 401(k) money into an IRA after you've left your employer or retired, you could convert all or a portion of those assets to a Roth IRA at that time. If you made that shift in 2017, you're eligible to recharacterize (up until the October 2018 deadline), but if you make that move in 2018 or after, a recharacterization is off the table. 

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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